If This Analyst Is Right, Square Stock Is About to Crash

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SQ stock - If This Analyst Is Right, Square Stock Is About to Crash

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Square (NYSE:SQ) had a rough Monday. SQ stock fell almost 9% on its heaviest volume since March as sellers swamped the company’s shares. This offered a stark contrast to recent trading; Square stock had surged from $65 to $100 since August.

With SQ stock down 15% from its recent high, it might seem like a great buy-the-dip opportunity here. But it is imperative that you understand the risks that the company is facing. For that, let’s take a look at analyst Mark Palmer’s scathing report on SQ stock released Monday.

A Red Flag from a Square Stock Bull

Mark Palmer and Giuliano Bologna of BTIG released this incredible research report about Square on Monday. Remember that Wall Street prefers “buy” ratings to anything else. When they say “neutral” or “hold”, it is often expressing that they actually have concerns about the company. And when an analyst uses the rare “sell” call, it generally is a conviction belief.

When an analyst says buy and the stock goes down, little happens. But if an analyst calls sell and the stock goes up, his or her bank tends to get upset for ruffling feathers with the company.

During the dot-com boom, for example, analysts at top-tier investment banks were infamously assigning “buy” ratings to companies while describing them as trash in internal emails to colleagues. But the analysts didn’t want to risk offending the companies, since the investment banks got so much money from selling stock and bonds for these flailing dot-com firms.

SQ Stock: Worth $30?

Palmer starts off his report by suggesting that Square stock is a sell and that it is only worth $30/share today. That’s a rather ambitious call, as it’d be 60% downside from current prices and represent new 52-week lows for the stock.

How does he arrive at that $30 target? To be fair, he’s not using wildly unrealistic numbers. He forecasts more than 20% annual revenue growth going forward, and suggests that EBITDA will almost triple between 2018 and 2020. Despite tripling, EBITDA would reach just $686 million in 2020, and a typical 20x EBITDA multiple (for a high-growth company) leaves you with a $30 stock price.

If Mr. Palmer’s assumption that EBITDA triples between now and 2020 is correct, then how do other analysts value Square stock at $100/share and above?

Either they assume significantly faster revenue growth, or they believe that the market will be willing to pay much more (60x EBITDA in this case) for shares. Unfortunately for the bulls, a typical S&P 500 company’s EBITDA multiple would be closer to 12x; Palmer is already being nice giving Square 20x as a tech growth company. 60x would be a rather ridiculous valuation.

Square: A Bank Disguised as a Tech Company?

Arguably, Square stock faces a huge problem. Its recent revenue growth is coming in large part from its credit operations. Previously, Square started lending to the small business merchants that used its platform. That’s all fine and well, assuming the company underwrites risk competently.

But the market is willing to pay far less for earnings off of credit lending than it is off of payment processing.

Think about it, banks tend to sell for 15x earnings or less in a normal economy (to say nothing of even lower EBITDA ratios). The market never assigns huge valuation multiples to banks because there is an inherent black box factor. It is hard to understand earnings, and if the loan book goes bad, the banking franchise can be crushed within a few quarters.

The more Square pivots to lending, the less attractive it will be as a growth or tech company. Which leads to Palmer’s latest concern. Square recently announced that it will also start lending to end consumers who pay through Square. These will be short-term consumer loans at APRs of 0% to 24%. Palmer notes that other consumer lending platforms charge significantly more than this.

The implication is that Square is not charging enough interest to make these loans an attractive risk/reward proposition.

Now, to be sure, in a booming economy, consumers will largely pay their debts. Square will look more profitable for adding more lending exposure. But what happens when a recession hits? We saw how badly things went for consumer finance platform LendingClub (NYSE:LC) when even a whiff of bad loan exposure and scandal hit.

SQ Stock Could Rally, but Beware of Risk

Now to be clear, bulls can point some reasonable holes in Palmer’s exceptionally bearish argument. For one, the perceived credit risk that Square is taking may be overblown.

Square has already started selling many of the loans it makes to merchants to third parties. In doing so, Square collects a profit on originating the loan, and other end parties take the credit risk. At least in theory.

As we saw in the 2008 housing bust, the bad mortgage underwriters still ended up getting swept out to sea when a recession hit despite appearing safe prior to the storm. Additionally, LendingClub also sold much of its exposure to third parties, but got stuck with enough of its own cooking to still demolish its stock.

On valuation, it’s easier to argue that the $30 price target is too low. If you value SQ stock closer to a bank, than the current $85 share price is absurd. But the market loves payment processors right now, and as long as Square can stay categorized in that field, its stock could remain resistant to traditional valuation metrics awhile longer.

SQ stock looks like a nice opportunity to buy a big correction with tech stocks in general suffering. However, I’d forgo that first instinct and keep searching through other tech opportunities.

While Palmer’s price target is almost certainly too pessimistic over the next 12 months, he makes a lot of compelling points. I don’t think it’d be any big surprise if SQ stock traded back to, say, $70. That’d still be more than 80x forward earnings and would hardly undersell Square’s future potential.

At the time of this writing, Ian Bezek had no position in the aforementioned securities.

Ian Bezek has written more than 1,000 articles for InvestorPlace.com and Seeking Alpha. He also worked as a Junior Analyst for Kerrisdale Capital, a $300 million New York City-based hedge fund. You can reach him on Twitter at @irbezek.


Article printed from InvestorPlace Media, https://investorplace.com/2018/10/square-stock-is-about-to-crash/.

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